Diversification is the strategy to reduce risk by investing in different types of assets with different risk / return characteristics. If you split your investments among multiple asset classes, the overall impact on your portfolio, if one investment gives lower than expected returns, is significantly lesser. The old idiom, “don’t put all your eggs in one basket” is the essence of diversification in financial planning.
In this blog post we will discuss about the importance of diversification, different avenues of diversification and how responsible investment is a beneficial way to diversify.
Why do you need to diversify?
- Asset prices and performances are subject to market risks, but if you diversify across different asset classes or sub-classes, then underperformance of a particular asset will only have a limited impact on your investments. Diversification is essential to risk reduction and is one of the most important aspects of financial planning.
- We have different financial goals in life, e.g. saving for a vacation, buying a car, buying a house, facing unexpected exigencies which life may throw at us, children’s education, children’s marriage, retirement planning, leaving an estate for our loved ones. These goals may be short term, medium term or long term in nature. You need to diversify your investments to achieve different financial goals within the required time-frames.
Suggested reading: What is goal based Financial Planning
- Diversification can protect your wealth from the vagaries of investment cycles (bull and bear markets). Asset prices always move in cycles. A period of high returns may be inevitably followed by period of low or even negative returns. Different asset classes have different investment cycles e.g. bear market for equity can be bull market for gold and vice versa. Diversifying across different asset classes provides relative stability to your investment portfolio across different investment cycles. This is also known as asset allocation.
- Risk and return have a direct relationship – if you take low risk, you will get low returns and vice versa. Diversification is needed for balancing risk and returns which is essential to meet your financial goals. Lack of diversification can either expose you to high risks or result in low returns, both of which can lead you to falling short of your financial goals. Investment products of different risk profiles are suitable for different financial goals e.g. long term, medium term and short term.
Asset class diversification
Different asset classes, e.g. fixed income, equity, gold etc. have different risk return characteristics. Investors should understand that, risk and return are directly related; higher the risk, higher the return and vice versa. Fixed income or debt has relatively lower risks as compared to equities. Gold is next risk grade; it has higher risk compared to fixed income, but lower risk compared to equity. Equity, generally, has high risk, but also gives high returns over sufficiently long investment tenure.
Different asset classes also outperform each other in different economic cycles. Fixed income may outperform equity in bear markets, while equity may outperform fixed income in bull markets. Similarly gold and equity cycles are different.
The chart below shows the growth of Rs 10,000 investment in equity (Nifty 50 TRI), fixed income or debt (Nifty 10 years Benchmark G-Sec Index) and Gold over the last 10 years ending 31st December 2020. Diversifying across asset classes will reduce volatility and bring stability to your portfolio.
Source: National Stock Exchange, Advisorkhoj Research (31.12.2020). Disclaimer: Past performance may or may not be sustained in the future
You may also like to read what is volatility and how to deal with it
Role of diversification in financial planning
- Different asset types are suitable for different investment tenures and objectives. Equity can be suitable for long term investing and gold can be used to hedge against inflation. The chart below shows the 20 year CAGR returns of different asset classes i.e. equity represented by Nifty 50 TRI, gold represented by Gold (INR) and fixed income represented by Nifty 10 year benchmark G-Sec Index. A mix of equity and fixed income may be suitable for medium term goals. For short term goals, you may only consider fixed income.
Source: National Stock Exchange, Advisorkhoj Research (Period: 01.01.2001 to 31.12.2020). Nifty 50 TRI represents equity, Nifty 10 year Benchmark G-Sec Index represents fixed income and Gold (INR) represents domestic value of Gold, All returns are CAGR. Disclaimer: Past performance may or may not be sustained in the future.
- If your investment goal is capital appreciation then equity mutual funds may be suitable investment options. Within equity funds, you can invest in large cap, midcap or small cap funds depending on your risk appetite.
- If you need income from your investments, then fixed income or debt is the suitable asset class. Within fixed income asset class, different types of debt funds can meet different types of financial goals. For example, overnight and liquid funds are suitable for very short term investments (less than 1 year), while dynamic bond funds and other longer term debt funds are suitable for longer term investments.
- You can get exposure to gold by investing in Gold Exchange Traded Funds (ETFs) or Gold Fund of Funds. Gold ETFs are much more cost efficient than physical gold e.g. gold jewellery because physical gold may have impurities and may require storage costs (e.g. bank locker fees).
- A diversified mix of asset types can help you meet each of your financial planning goals without compromising the other. Diversification is an integral element of prudent financial planning. Equity is the ideal asset class for long term goals, while fixed income is suitable for short term goals. Equity is suitable for generating inflation beating returns with potential for wealth creation in the long term. Gold is used as a hedge against inflation. Gold is also usually counter-cyclical to equity i.e. gold outperforms in investment cycles where equity underperforms and vice versa. A diversified mix of asset classes can balance risks and produce optimal returns for your goals.
- Related read how asset allocation helps diversify your investments
- Asset rebalancing is an important part of diversification. Different asset types / classes grow in value at different rates during different economic cycles or market conditions. By rebalancing assets from time to time, investors can take advantage of price to value opportunities in different asset types. Financial analysis shows that, asset rebalancing can improve risk adjusted returns over a sufficiently long investment horizon. Mutual funds provide investors with the benefit of asset rebalancing which provides portfolio stability, reduced downside risks and superior risk adjusted returns.
In this blog post, we discussed how diversification is beneficial in terms of reducing risks, ensuring portfolio stability in different market cycles and in financial planning. We also discussed how mutual funds can be used to achieve multiple diversification objectives and benefits. Every investor should have a financial plan to meet their different financial goals along and a diversified portfolio across different asset classes (e.g. equity, debt and gold) to help them meet their different goals. Investors should consult with their financial advisors on how to build a diversified portfolio suitable for their investment needs and risk appetites.
Issued as an investor education initiative by HSBC Mutual Fund.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.